A 401(k) is offered by your employer while IRAs are retirement accounts that you open on your own. While one option is generally enough to build a reserve of wealth after you retire, there is no reason why you can’t have both.
IRA – Individual Retirement Account
A traditional IRA enables individuals to make contributions without taxation and your investments through this account can grow tax-free. However, you will have to pay regular income tax on your final IRA withdrawal.
Traditional IRAs can be opened through an online broker, a robo-advisor, or a bank. With an online broker, you will be able to invest in stocks and bonds. Bank IRAs, on the other hand, typically offer Certificates of Deposit and savings accounts. You can invest your money in various ways.
With an IRA account, you can invest in stocks, bonds, and other assets. How much your earnings grow or shrink every year depends on how you invest. If you are saving for a long-term goal like retirement, stocks and bonds have historically proven to be the best choice, with higher returns.
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How You Can Invest?
Your contributions are limited. You can invest $6,000 every year according to the 2020-2021 rules ($7,000 for 50 years or older), even if you are already contributing to a 401(k) or another workplace savings plan.
Contributions you make are tax-deductible. For instance, if you have earned $50,000 and you contribute $6,000 to a traditional IRA, then you will only have to pay income tax on $44,000 that year if you qualify for deductions.
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Rules for Withdrawal
There are some rules for withdrawing. Your Traditional IRA investments are not taxed until you make a withdrawal. Also, keep in mind that early withdrawal will be taxed as regular income and you will have to pay an additional penalty as well. Traditional IRAs are different from Roth IRAs. With Roth IRAs, your contributions are not tax-deductible, but your withdrawals are tax-free in retirement.
Typically, you can begin taking money from a traditional IRA after you are 59 ½ years old. When the money from your traditional IRA is released, you will have to pay regular income tax. For early withdrawal, before age 59 1/2, you may be charged a 10% penalty, except for college tuitions, or mortgages, etc. You can choose to not take your IRA distributions when you turn 59 ½, you can delay it till you are 70 1/2.
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401(k)
A 401(k) is an employee retirement plan offered by employers to their employees. With a 401(k) account, a portion of your salary goes into the account before taxes. The same amount is matched by the employer and deposited into the account. Similar to IRAs, the 401(k) offers tax deductions for both the employer and the employee. Returns that come from a 401(k) are tax-free until withdrawal.
The contribution limits for employees are $19,500 per year for those under the age of 50 and $26,000 for those above the age of 50.
The combined annual employer/employee contribution towards a 401(k) is capped at $58,000 for those under 50 years old and $64,500 for those over 50 years old. The penalty fee for 401(k)s for premature withdrawal is the same as a traditional IRA.
You Can Have Both
The end goal of both an IRA and a 401(k) is to create a nest egg for your life after retirement. However, choosing between the two depends on your needs.
401(k) enables account holders to make larger annual contributions than IRAs. However, investment options in a 401(k) are limited and the account holder has no say in where the money is invested. IRAs, on the other hand, have lower limits on annual contributions but offer wider investment options. IRAs also give investors the opportunity to manage their investment themselves and have more control over it, while 401(k)s do not.
If you have the financial ability to contribute to both the IRA and 401(k), then it is definitely something you should consider doing.
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Retirement Goals
Since 401(k)s have employer contributions, it significantly increases the amount you can save. If your employer matches 100% of your contribution, and you also have the financial ability to invest in an IRA, there’s nothing better for your retirement goals. On the other hand, if your employer does not match your 401(k) contribution, you can invest in an IRA of your choosing and even increase your contribution to your 401(k).
Investing in a 401(k) means less of your income is taxable than if you invest in an IRA. Moreover, if you see your income rising significantly over the next few years, increasing your 401(k) contribution may help you keep your taxable income low as you keep building a healthy nest egg.
